FINS1613 Lecture Notes - Lecture 6: Dividend Yield, Total Return, Preferred Stock

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aquamarinegoat534

2 Sep 2018

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Return from investment comes from two sources: dividend payments: payments made to shareholders; uncertain and not guaranteed, sale price: market price of the stock exchange when the stock is sold. Terminology: ticker: a unique abbreviation assigned to each publicly traded company, share type: an ordinary share gives rights to ordinary dividends and voting rights for directors, mergers or other events. A preference share gives rights to preference dividends, but typically lacks voting rights: exchange: stock market where investors may buy and sell the stock. Equity cost of capital or cost of equity (re) is an expected return of other investments a(cid:448)aila(cid:271)le i(cid:374) the (cid:373)a(cid:396)ket (cid:449)ith e(cid:395)ui(cid:448)ale(cid:374)t (cid:396)isk to the fi(cid:396)(cid:373)(cid:859)s sha(cid:396)es, i. e. dete(cid:396)(cid:373)i(cid:374)ed (cid:271)y (cid:373)a(cid:396)ket and firm risk. It is the return on stock including dividends: this is the discount rate, expected total return of a share should equal its equity cost of capital.

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A CAPITAL BUDGETING CASE

The E-Check Company, a manufacturer of pollution detection systems, has enjoyed considerable success. In 2015, the company completed its 25^th year in business and generated a return on common equity of 20%. Rusty Rivet, Company C.E.O., is certain the Company can continue this performance. One thing that contributes towards his confidence is that almost all of the Companyâs sales are to governmental programs that, in order to help control pollution, force residents in communities located next to interstate highways to pay a fee to have their vehicle emissions systems tested. Given the high test pass-rates, the pollution in these areas obviously comes largely from traffic passing through the communities rather than from the localâs vehicles, but governments have come to rely on the income emission testing generates and are reluctant to cut the testing requirements. Another reason for his confidence is the fact that most of the Companyâs top managers hold an advanced engineering degree awarded by a variety of prestigious universities. Rusty also believes that stockholders like the fact that the Company pays out all earnings not needed to pay preferred dividends as common dividends (and because he is the majority stockholder in the Company it is unlikely this policy will change). It is estimated that the common dividend will continue to grow annually at an 8% rate.

In January 2016, managers of the Company have expansion plans; they have just completed an evaluation of six capital budgeting projects. The net cash flows (in millions of dollars) and risk assessment of each project are shown below. Company policy requires that average risk projects have an IRR at least equal to the Companyâs weighted average cost of capital (WACC). Policy also requires that the hurdle rate be increased (decreased) by 250 basis points when evaluating projects that are above (below) average risk. Management has determined that the Companyâs WACC is 9.63% and, therefore, management is making plans raise $52 million to implement all of the projects except Project E. As a part of your management training, you have been asked to review the analysis. In particular, management wants you to verify both the WACC calculation and project selection.

Project A B C D E F

0 (10) (12) (15) (5) (11) (10)

1 3.15 4.3 7 2 0 1

2 3.15 4.3 6.4 2 0 3

3 3.15 4.3 5.5 1 0 5

4 3.15 4.3 .5 0 3

5 3.15 .5 0 .55

6 .5 0

7 0

8 22

Risk High Ave. Ave. Low Ave. Low

The Company has one outstanding bond issue. It has an annual stated rate of 8% with annual interest payments. $50,000,000 of the bond issue, with an original term to maturity of 15 years was publicly placed 7 years ago at face value. The most recent price at which a bond traded on the secondary market was $900 (a $100 discount from face value). Any new long-term debt would be raised in the form of a new bond issue. Matilda Angle, E-Checkâs treasurer, has pointed out that the company would like any new bond issue to have an initial maturity of 15 years to lock in the interest rate for a long time, and she also points out that the good news is that the yield curve at this time is essentially flat. In addition, any new bond issues will be privately placed so there will be no flotation costs.

The company has 10 million shares of $1 par common stock outstanding. These shares are currently trading for $10.00 per share on the Cincinnati Stock Exchange. The company paid total dividends of $1,700,000 on these shares during 2015. The companyâs underwriter will charge flotation costs equal to 10% of the value of any new shares sold.

The company also has 100,000 shares of $200 par preferred stock outstanding. These shares are currently trading at $175 per share. The preferred share annual dividend (paid quarterly) is 9.5%. The underwriter will charge flotation costs of 5% of the value of new shares sold.

Managementâs WACC Calculation

Shown below are E-Checkâs simplified financial statements for 2015. Managers used information from the balance sheet to come up with the weights for their WACC calculation.

E-Check

Balance Sheet

December 31, 2015

Current assets 30,000,000 Current liabilities 30,000,000

Long-term assets 88,000,000 Long-term liabilities 50,000,000

Total assets 118,000,000 Total liabilities 80,000,000

Common shares 10,000,000

Preferred shares 20,000,000

Retained earnings 8,000,000

Total equity 38,000,000

Total liabilities & equity 118,000,000

E-Check

Income Statement

2015

Revenues 200,000,000

Cost of goods sold 110,000,000

Gross profit margin 90,000,000

Operating expenses 80,000,000

Operating income 10,000,000

Interest expense 4,000,000

Taxable income 6,000,000

Income tax 2,400,000

Net income 3,600,000

Specifically, the WACC was calculated as follows:

WACC = (K_d * wt_d) + (K_p * wt_p) + (K_e * wt_e)

= (8 * (80/118)) + (9.5 * (20/118)) + (17 * (18/118))

= 5.423 + 1.61 + 2.593

= 9.63%

Maria Sliderule, Company controller, has explained to you that 8% was used as the cost of debt because this is the stated rate of interest on the firmâs existing bond issue; 9.5% was used as the cost of preferred shares because this is the dividend rate on the Companyâs preferred stock, 17% was used as the cost of equity because dividends of $1.7 million were paid on the common shares with a book value of $10 million; and that the weights in the WACC calculation were derived directly from the balance sheet.

Internal announcement of the expansion possibilities has fostered some debate. One manager, Mel Lever, asserts that the Company should raise all the money needed in the form of debt, and since the cost of debt is only 8%, all projects should be accepted. Olm Meter, a Norwegian engineer who just joined the E-Check management team, argues that it makes no sense to invest in a project with an IRR less than the WACC. The input of all these individuals cannot be ignored because each is a valuable member of the management team and highly respected in the area of pollution detection technology. This is why you have been asked to review the analysis.

1. Please address the comments of Mr. Lever and Mr. Meter.

2. In which of the proposed capital budgeting projects should the Company invest?

3. What do you think is the Companyâs WACC?

4. List any errors in the 9.63% calculation?

orchidcrow953

1) The subarea of finance where you need to value uncertain cash flows occurring at different points in time is:

a. investments

b. corporate finance

c. capital markets

d. bank management.

e. all of the above subareas

2) Which of the following statements is correct?

a. One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a partnership.

b. Corporations face fewer regulations than sole proprietorships.

c. One disadvantage of operating a business as a sole proprietor is that the firm is subject to double taxation, because taxes are levied at both the firm level and the Owner level.

d. It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents ace required.

e. If a partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business.

3) Which of the following statements is correct?

a. Corporations generally face fewer regulations than sole proprietorships.

b. Corporate shareholders are exposed to unlimited liability.

c. It is usually easier to transfer ownership in a corporation than in a partnership.

d. Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation.

e. Less of a corporation's income is generally subject to federal taxes.

4) The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to:

a. Maximize its expected total corporate income.

b. Maximize its expected EPS.

c. Minimize the chances of losses.

d. Maximize the stock price per share over the long run, which is the stockâs intrinsic value.

e. Maximize the stock price on a specific target date.

5) Which of the following is correct?

a. In most corporations, the CFO ranks above the CEO.

b. By Law in most states, the chairman of the board must also be the CEO.

c. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person.

d. The CFO generally reports to the firm's chief accounting officer, who is normally the controller.

e. The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but he or she is not responsible for the validity of the financial statements, as the controller and the auditors have that responsibility.

6) The primary operating goal of a publicly-owned firm trying to best serve its stockholders should be to

a. Maximize managers' own interests, which are by definition consistent with maximizing shareholders' wealth.

b. Maximize the firmâs expected EPS, which must also maximize the firmâs price per share.

c. Minimize the firmâs risks because most stockholders dislike risk in turn, this will maximize the firmâs stock price.

d. Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers.

e. Since it is impossible to measure a stock's intrinsic value, the text states that it is better for managers to attempt to maximize the current stock price than its intrinsic value.

7) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and bondholders?

a. Compensating managers with stock options.

b. Financing risky projects with additional debt.

c. The threat of hostile takeovers.

d. The use of covenants in bond agreements that limit the firmâs use of additional debt and constrain managers' actions.

e. Abolishing the Security and Exchange Commission.

8) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and managers?

a. Pay managers large cash salaries and give them no stock options.

b. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover.

c. Beef up the restrictive covenants in the firmâs debt agreements.

d. Eliminate a requirement that members of the board of directors must hold a high percentage of their personal wealth in the firmâs stock.

e. For a firm that compensates managers with stock options, reduce the time before options are vested, i.e., the time before options can be exercised and the shares that are received can be sold.

9) Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders?

a. Decrease the use of restrictive covenants in bond agreements.

b. Take actions that reduce the possibility of a hostile takeover.

c. Elect a board of directors tlta.t allows managers greater freedom of action.

d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.

e. Eliminate a requirement that members of the board of directors have a substantial investment in the firmâs stock.

10) Which of the following is correct?

a. Potential conflicts between stockholders and bondholders are increased if a firm's bonds are convertible into its common stock.

b. Because bankruptcy requires that corporate bondholders be paid in full before stockholders receive anything, bondholders generally prefer to see corporate managers invest in high risk/high return projects rather than low risk/low return projects.

c. There is no good reason to expect a firmâs stockholders and bondholders to react differently to the types of assets in which it invests.

d. Stockholders should generally be happier than bondholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

e. Bondholders should generally be happier titan stockholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

11) You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following best describes this transaction?

a. This is an example of a direct transfer of capital

b. This is an example of a primary market transaction.

c. This is an example of an exchange of physical assets.

d. This is an example of a money market transaction.

e. This is an example of a derivative market transaction.

12) Which of the following statements is correct?

a. The NYSE does not exist as a physical location. Rather it represents a loose collection of dealers who trade stock electronically.

b. An example of a primary market transaction would be your uncle transferring 100 shares of Walmart stock to you as a birthday gift.

c. Capital market instruments include both long-term debt and common stocks.

d. If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los Angeles, this would be a primary market transaction.

e. While the two frequently perform similar functions, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise large blocks of capital from investors.

13) Which of the following is a primary market transaction?

a. You sell 200 shares of IBM stock on the NYSE through your broker.

b. You buy 200 shares of IBM stock from your brother. The trade is not made through a broker--you just give him cash and he gives you the stock.

c. IBM issues 2,000,000 shares of new stock and sells them to the public through an investment banker.

d. One financial institution buys 200,000 shares of IBM stock from another institution. An investment banker arranges the transaction.

e. IBM sells 2,000.000 shares of treasury stock to its employees when they exercise options that were granted in prior years.

14) Money Markets are markets for:

a. Foreign currencies.

b. Consumer automobile loans.

c. Common stocks.

d. Long-term bonds.

e. Short-term debt securities such as Treasury bills and commercial paper.

15) You recently sold 200 shares of Disney stock, and the transfer was made through a broker. This is an example of:

a. A money market transaction.

b. A primary market transaction.

c. A secondary market transaction.

d. A futures market transaction.

e. An over-the-counter market transaction.

16) Which of the following statements is correct?

a. Hedge funds are legal in Europe and Asia, but they are not permitted to operate in the United States.

b. Hedge funds are legal in the United States, but they are not permitted to operate in Europe or Asia.

c. Hedge funds have more in common with investment banks than with any other type of financial institution.

d. Hedge funds have more in common with commercial banks than with any other type of financial institution.

e. Hedge funds are not as highly regulated as most other types of financial institutions.

17) Which of the following factors statements is correct?

a. The New York Stock Exchange is an auction market, and it has a physical location.

b. Home mortgage loans are traded in the money market.

c. If an investor sells shares of stock through a broker, then it would be a primary market transaction.

d. Capital markets deal only with common stocks and other equity securities.

e. While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.

18) Which of the following statements is correct?

a. The term "IPO" stands for Introductory Price Offered, and it is the price at which shares of a new company are offered to the public.

b. IPO prices are generally established by the market, and buyers of the new stock must pay the price that prevails at the close of trading on the day the stock is offered to the public.

c. In a "Dutch auction," investors who want to buy shares in an IPO submit bids indicating how many shares they want to buy and the price they are willing to pay. The company determines how many shares it wants to sell. The highest price that enables the company to sell the desired number of shares is the price that all buyers must pay.

d. It is possible that the price set in an IPO is so high that investors will refuse to buy the number of shares that the company wants to sell. In this situation, the IPO is said to be oversubscribed.

e. It is possible that the price set in an IPO is so low that investors will want to buy more shares than the company wants to sell. In that case, the company will have to issue more shares than it wants to sell.

19) The stock market is thought to be efficient because:

a. There are many brokers working the exchange floors

b. Computers can make very fast calculations these days

c. There are many stock analysts following the same stocks

d. Stocks are available and are very inexpensive

e. Speed trading is now an acceptable trading technique

20) If the stock is priced correctly but with better management the firm could be worth even more, then the firm would be:

a. A potential target for a stock investor

b. A potential target for a private equity firm

c. A potential target for a bond fund

d. A potential target for the SEC

e. A potential target for share repurchases

Skinner Industries from Conway, North Carolina has found an exclusive market in supplementary equipment to support the ever increasing motor sports market. In the last ten years, the company has filed for patents on the portable fuel dispenser, power lug nut remover, and the removable transparent windshield protector. Each of these items is critical when the race car drivers have to make a pit stop during a race. When seconds count, having the best available equipment can mean millions in prize dollars and sponsorship support.

Sherry Skinner has always been a big fan of motor sports having grown up in Conway, North Carolina and going with her dad to many races during her youth. Sherry wanted to be a part of the action of motor sports, but since this was a male dominated sport, she knew it could not be as a driver, member of the pit crew or working in the engine shop. While the sport does have a few female drivers, Sherry did not want to be a token, and she felt her gifts and talents could be better utilized in other venues.

Sherry loved engineering, and went to Duke for her engineering degree. After excelling in college, she had her choice of jobs at major companies around the country. However, Sherry passed up the prestige jobs and went back to her roots in Conway. She decided to start her own company and use her talents to develop unique products that could be used in the motor sports arena. Sherry knew that it would be hard to compete against the big boys and major automobile corporations when it came to the race cars, however she thought there could be a market in supplementary equipment items.

Growing up with the sport, Sherry always enjoyed the action on pit row. Races were often won or lost on how quickly the pit crew got tires changed and fuel added to the car. Sherry reasoned correctly that this part of the race would be a good place to start developing products. The two most critical activities during a pit stop were changing tires and adding fuel. Any equipment or product design which could enhance these activities would certainly have instant appeal.

After a great start to the company, Sherry took the company public nine years ago when Skinner Industries was just three years old. 1,200,000 shares of common stock were issued at a price of $10 per share through the mid-Atlantic regional exchange.

The company has continued to prosper and enjoy a good growth rate as the motor sports craze has mushroomed. In 20x3 the Skinner Industries growth rate in earnings was 6% and in 20x4 the growth rate was 5%. Sherry does not want the company to become too large, as she still likes the feeling of a âdown homeâ business with the boys. At the same time, the business is virtually guaranteed to grow just because of the motor sport market itself.

Sherry is happy with the current 5% growth rate and to support that projection she is planning on a $3,000,000 capital expansion program in 20x5. She is currently close to capacity with many of the operations and without the continued expansion the desired growth could be in jeopardy.

So far, Sherry has been able to maintain a reasonable increase in long-term assets without having to initiate subsequent issues of stock. She would like to continue funding growth through both the company profits and with favorable bank loans. Ideally, the company wants to maintain a target equity ratio of 70% of the total capital structure which includes long-term liabilities plus equity. Currently, the cost of borrowing is 11.5% before taxes. Sherry has also determined that the cost of equity is 13%.

When Sherry started the business, she was able to work out an attractive lending agreement for $5,000,000 in long-term bonds with a 15 year maturity. Part of the agreement with the bank was that Sherry establishes a sinking fund that would have to match the $5,000,000 in bonds one year prior to maturity. This provision would guarantee the bank collateral on the bonds but allow Skinner to earn some interest on marketable securities. As of the end of the current year, that fund has grown to $3,000,000 and Sherry is planning on adding $1,000,000 in each of the next two years. The bank also required that Sherry establish an appropriated retained earnings account equal to the amount of the collateral sinking funds so that she would be limited in the amount of dividends that could be declared and paid in any given year.

To supplement some of the recent expansion, Sherry had funded the increase in long-term assets with additional long-term notes. This funding has grown to $2,000,000 at the end of the current year. The financial institution providing these funds has identified some constraints on potential dividend payments based on the overall financial performance of Skinner. The company must maintain a current ratio of at least 1.20, a times interest earned ratio of at least 3.0, and a debt ratio no greater than 60%.

While the company is growing and there continues to be a need for capital expansion, Sherry also recognizes the need for dividends, and has established a once a year dividend payment at the end of the year. The investors seem to like their dividend bonus that comes in early February just before the start of racing season. Many of the investors are value conscious and want a return on their investment from both dividends and stock price appreciation. Since this is a regional company focusing on a very specific market, a large number of investors are motor sport fans from the mid-Atlantic area. Sherry has always believed in a significant dividend, last year it was $700,000, and the dividend yield is over 6.0%. The company has also maintained a pretty consistent dividend payout ratio through 20x3.

While everything seems to be going right for the company, with a reasonable growth rate in an exploding market plus an attractive dividend, Sherry is puzzled on why the market price of the stock at around $8 7/8 seems so low. Perhaps the overall economy, which is struggling and filled with uncertainty, is causing the price decline. Also, Sherry believes that the job market in North and South Carolina has suffered with many textile and similar jobs going overseas. In an effort to support the price of the stock and maintain the confidence of the investors, Sherry thinks it is important to retain and possibly even increase the current dividend per share for 20x4.

Sherry has just received the financial statements as of December 31, 20x4 without the inclusion of a 20x4 dividend payment. She needs to determine what annual dividend payment the company should make for 20x4. She also wanted to see what happened last year so she obtained the income statement and balance sheet from 20x3 along with the balance sheet figures at the end of 20x2. The corporate tax rate is 40%.

Skinner Industries
Income Statement
As of December 31
Dollars in $1,000s
		20x3	20x4
Sales		23,500	26,150
Cost of Goods Sold		14,700	16,990
Depreciation		1,750	1,840
Gross Margin		7,050	7,320
Operating Expenses		2,850	2,900
Operating Income		4,200	4,420
Financing Expenses		1,300	1,370
Net Income Before Tax		2,900	3,050
Taxes		1,160	1,220
Net Income		1,740	1,830

Skinner Industries
Balance Sheet
As of December 31
Dollars in $1,000s
	20x2	20x3	20x4
Cash	950	1,000	800
Marketable Securities	2,260	2,750	3,000
Accounts Receivable	4,000	4,130	4,850
Inventory	8,300	8,640	9,570
Total Current Assets	15,510	16,520	18,220
Long-Term Assets (net)	17,500	18,380	20,360
Total Assets	33,010	34,900	38,580

Accounts Payable	6,200	6,270	7,050
Accruals	1,500	1,530	1,600
Short-Term Notes Payable	4,500	5,000	5,500
Total Current Liabilities	12,200	12,800	14,150
Long-Term Liabilities	6,250	6,500	7,000
Total Liabilities	18,450	19,300	21,150

Common Stock	12,000	12,000	12,000
Retained Earnings - Appropriated	1,700	2,250	3,000
Retained Earnings - Unappropriated	860	1,350	2,430
Total Equity	14,560	15,600	17,430
Total Liabilities & Equity	33,010	34,900	38,580

1. What amount should Sherry declare in dividends for 20x4? Identify what factors influenced your decision and how they helped you in determining the dividend amount.

FINS1613 Lecture Notes - Lecture 6: Dividend Yield, Total Return, Preferred Stock

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